Soaring Short Volatility Trades Pose New Threat to Stocks

Back on Feb. 5, a popular trading strategy called short volatility, or short vol, blew up, creating massive losses for speculators. Some investment products based on the strategy lost almost their entire value, and had to be liquidated. Undaunted by that experience, speculators subsequently began making heavy short vol bets once again, and net short positions in futures contracts linked to the CBOE Volatility Index (VIX) are now even bigger than they were at the start of February, Bloomberg reports.

In the course of the recent market pullback, on Oct. 11 the VIX shot up to its highest level since February, creating losses for short vol speculators of about $420 billion, according to Lincoln Edwards, a principal at Austin, Texas-based hedge fund Houndstooth Capital Management, per Bloomberg. The magnitude of the biggest selloffs in 2018 are presented in the table below.

Significance for Investors

The VIX captures traders' forecasts of volatility in the S&P 500 Index (SPX) over the next 30 days, based on the trading of options contracts linked to that index. The VIX is often called a fear index for the market, and it tends to rise during market declines. The short vol trade is a bet that the VIX will remain stable or decline, and this proved to be a winning wager through most of 2017, and into the early part of 2018.

However, when U.S. stocks declined sharply on Feb. 5, with the S&P 500 down by 4.1% and the Dow Jones Industrial Average (DJIA) off by 4.6% for the day, the VIX spiked, producing huge losses for short vol trades. Now, as in February, a sharp market pullback accompanied by a big uptick in the VIX can send these speculators scrambling to cover their short positions by selling other equity holdings, thereby sending the markets down yet further. As a result, the rise in short vol trading may be an indicator of rising downside risk for all equity investors. The risks are summarized below.

How Short Vol Trades Are Boosting Risk

Net short positions in VIX futures are at the highest level since February.

Short selling of any financial asset is a highly risky proposition, given that it entails assuming theoretically unlimited downside risk, as Bloomberg notes. Nonetheless, hedge funds have returned in force to the short vol game. "As long as central banks take a gradual and incremental pace of deleveraging, and their rhetoric continues to actually function as a volatility absorber, the short vol carry will still make money," as Yannis Couletsis, director at volatility hedge fund Credence Capital Management Ltd., told Bloomberg.

On the other hand, according to Pravit Chintawongvanich, an equity derivativesstrategist at Wells Fargo, "Sudden bursts of volatility have become a more frequent phenomenon in recent years," per Bloomberg. He finds six such events since 2007, compared to only five in the previous 50 years. It is precisely these bursts that produce massive losses on short vol bets.

Looking Ahead

Inigo Fraser-Jenkins, head of global and quantitative European equity strategy at Sanford C. Bernstein & Co., thinks that volatility is headed higher on a long-term basis, according to Business Insider. If so, that would finally mean the end of the short vol trade as a viable investment strategy, while also suggesting that all investors should brace themselves for bigger market swings, including more violent downdrafts.